How will a down payment affect a mortgage loan by the seller?

A down payment will create equity in the property and give the seller money to deal with foreclosure.

Seller financing is almost always going to be a second mortgage that is subject to the first mortgage from the bank. The bank's loan is usually for the majority of the purchase price and stands first in line to get paid. If the buyer fails to pay on the first mortgage, the lender on it will foreclose and the seller-financed mortgage will be wiped out. If the sale pays off the first mortgage balance, including all delinquencies and foreclosure costs, and there is money left over, the seller will get this money up to what is owed on the mortgage. It seldom happens. You can bring the first mortgage current and add that amount onto your mortgage. This will put the borrower in default on your mortgage if the added money is not paid with the next regular payment after you have informed the borrower of your actions and demanded payment. You can then begin your own foreclosure. If you foreclose, you will either be paid off at the sale or get back the property if no one bids enough to enable a payoff (usually the latter). If there was equity in the property, the owner would probably have sold it to avoid foreclosure.

Once you get back the property, you will be responsible for the first mortgage payment. Foreclosure of a first mortgage wipes out the second (third, fourth, etc.). Foreclosure of a second mortgage does not affect the first. There are problems that may arise.

• If the first mortgage is for a high amount, making up the delinquency may require more money than you can afford. This is especially true if the first mortgagee waited until the borrower was several months behind on the payments before starting the foreclosure process.

• The holder of the first mortgage may claim that the foreclosure triggers a due on sale clause and demand payment. However, most state laws do not allow this. Check the applicable law in your state.

• Borrowers in possession of property being foreclosed upon usually do not take care of the property. Some deliberately damage it. If the second mortgage is for a relatively small amount, make sure the added expense to get ownership of the property is worth it.

For more detailed information on mortgage priorities, refer to Chapter 15 on junior loans.

Can a seller finance the total purchase price?

A seller could finance and take a mortgage for the total purchase price. Now the transaction is strictly between the seller and the buyer. There is no first mortgage lender to qualify the buyer or to deal with in a foreclosure. It is all up to the seller.

In some parts of the country, a seller customarily uses an attorney to facilitate the sale. If you live in a state where lawyers are used for home sales, be sure that you consult yours before signing anything obligating you to receive a mortgage as all or part of the purchase price. If you live in a state where attorneys are not customarily used for home sales, you should consult one anyway. Some state bar associations certify lawyers as experts in real estate transactions. Call your local bar association first. If your state bar cannot give you the name of a qualified attorney, a recommendation from your bank or title company can usually help.

Have the attorney either draw the note and mortgage or examine the one that you plan to use. This is especially important if you plan to sell the mortgage. You must be sure that your note is a negotiable instrument. If not, you will have difficulty selling it. There are whole courses in law school on negotiable instruments, but the important thing to know is that the documents must be drawn (written) properly to be negotiable, and a buyer of the note and mortgage will want negotiability.

Are there scams a seller financing the purchase price should be aware of?

There is a common scam in these transactions — a subordination clause in the mortgage. This clause states that the buyer can borrow money after your mortgage is recorded and gives the new lender a mortgage superior to yours. In these clauses, you agree to subordinate your mortgage to this later loan. In other words, your first mortgage will become a second mortgage or your second mortgage will become a third mortgage. Since higher mortgages wipe out lower (junior) mortgages, you can see the danger.

I call the subordination clause a scam. It is considered a strategy by some. Seminars on how to buy property with no money sometimes teach the subordination clause as a legitimate purchase method. This is why it is so commonly used. If you are asked by a prospective buyer to insert a subordination clause into the purchase money mortgage, you can be fairly sure that this buyer intends to borrow the full value of the property with a mortgage or mortgages superior to yours. After you subordinate, you will be left with worthless paper unless the property greatly increases in value.

Subordination clauses are also used when construction is involved. This is an entirely different situation; subordinating to a construction loan may be desirable for a seller of empty land to a developer. It is not a good idea for a seller of an existing home.

Can I sell the purchase money mortgage?

If you do decide to take back paper, you can keep the mortgage or sell it. The secondary market works for individuals, too. The difference is that you will not be selling yours to Fannie Mae. You will sell to a company or individual investor that buys purchase money mortgages.

The smart thing to do is investigate the market before agreeing to take the mortgage. Your real estate agent should have a contact that invests in these mortgages. You can find investors in the newspaper or on the Internet, but a personal recommendation is usually better. By doing this, you can get an idea of the discount you will have to give. The amount will depend on many factors, including rising or falling home prices. Do not expect the one or two points that apply to institutional lenders. You could have to discount your second mortgage by 50% or more. If you have the first mortgage for the majority of the purchase price, to sell it could require a 10%-30% discount. Again, there are many factors involved and you may have to give a much lower discount.

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